Hello, Power Profit Traders!
A sure sign that option premiums are highly inflated is when the Volatility Index (VIX) is at the high end of its range.
Typically, you’ll know the VIX is high when you see the general market declining.
And, when the VIX is high in a declining market, conditions are ripe for inflated option premiums – so, option buyers beware!
The VIX is on the rise, and this means option buyers will be paying a premium for options.
There’s really no reason to be on the wrong end of implied volatility, however. All you need to do is recognize when option premiums are inflated and avoid buying them at inflated prices.
Most option traders learn the lesson about over paying for options the hard way, but there are indications that options are overvalued. Instead of being an option buyer at these times, you can sell them to open and take advantage of the inflated premiums.
Benjamin Franklin wrote a letter about an experience he had in his childhood at age seven. On a holiday his friends gifted him with a pocket full of coppers. He went directly to the toy store, and while on his way he was charmed by the sound of a whistle from another boy. He then opened his pocket and offered and gave all his money for a single whistle.
He returned home whistling to his delight, and then his brothers, sisters and cousins informed and laughed at his purchase knowing he had paid four times as much for the whistle than it was worth.
After reflecting on his purchase, Franklin “cried with vexation; and the reflection gave me more chagrin than the whistle gave me pleasure.”
The lesson stayed with Ben for the rest of his life – consciously observing when others were paying more than they should in other walks of life.
I’ve seen traders open their pockets and pay too much for options all too often.
There are ways to know if you’re paying too much, however.
Broad Market Option Inflation
As I mentioned above, you can use the VIX as a broad-market gauge to identify option inflation. In the chart below, observe the highs and lows over this past year, and then look at the right side to see where the current VIX level is.
(VIX High/Low Levels and Current Trend)
You can see from the chart’s trend that volatility is on the rise, and it’s approaching some of this year’s highest levels.
To keep it simple, when the VIX is on the rise it illustrates that option premiums are rising due to increased demand and are essentially becoming expensive, or “overvalued.”
While the VIX can be used as a gauge for the broader market, the charts on Tom’s Option Tools can help narrow down option inflation on individual stocks.
Individual Stocks and Inflated Options
In the graph below you can see the levels of option Implied Volatility (IV) back to May of this year. You can see recently, however, that implied volatility is rising tremendously.
(I.V. BIIB May, 2022 to Present)
Biogen (BIIB) is one of ten stocks listed on my Tom’s Top Ten Watch List that can be seen in on the right side of this article. After the market closes each day, my Expensive Volatility is updated to show you my Top Ten stocks that have “expensive” options based on high implied volatility.
In the Biogen chart above, the red line indicates the fluctuating option premiums since early May, but you can see by the extreme elevation of the line that option premiums have recently been skyrocketing above “normal” levels.
Now, this doesn’t mean you need to stay away from the options on my Expensive IV Watch List, but instead, the tool is designed to help option buyers beware of over paying, while at the same time offering opportunities for option sellers to be on the right side of high-priced options.
With the Watch Lists on my Morning Report, you won’t need to open your pockets and give everything you’ve got to buy options! Instead, there may very well be some option selling opportunities knocking on your door.
I am always glad to learn lessons from others instead of learning the hard way. I hope you feel the same way!
Until next time!
Tom Gentile
America’s #1 Pattern Trader
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